What is a Bull Trap?
A bull trap is an investing term used to describe a situation in which the price of a security shows signs of increasing but then quickly reverses and falls. The investor, who has been expecting the price to continue rising, is now trapped and must either sell the security at a lower price or hold and wait for the price to rise again.
Bull traps can happen in any type of market but tend to be more common in bear markets – when the overall trend is downwards – because investors are more prone to miscalculating the direction of the market. Bull traps occur when the investor thinks that the security's price is going to increase due to positive news or developments, and they buy the security. Other investors who had the same idea may also buy the security, pushing the price up temporarily.
However, the price eventually falls back down as the false signal of increased demand is revealed. This often happens when the news or developments that had been driving the temporary rise turn out to be baseless. Investors who have bought the security at a higher price must now sell at a lower price, resulting in losses.
Bull traps are a form of market manipulation, as traders and investors attempt to drive up the price of a security by making it appear as though there is a rising demand for it. Such manipulation can be very profitable for the people involved, as they can buy the security at a lower price and then sell when the price rises temporarily.
Overall, bull traps are an important concept to understand for investors, as they can be a major source of losses. To avoid being caught in a bull trap, investors should do their due diligence and research a security before purchasing it, and should be wary of news stories and events that could drive up the price temporarily.
Simplified Example
A bull trap in investing can be thought of as a false promise of good news. Imagine you are hiking in the mountains and you see a trail sign that says "Refreshing Stream Ahead." Excited about the prospect of finding water, you eagerly follow the trail, only to find that the stream is dry. The sign was a trap, or false promise, that led you on a wild goose chase. In investing, a bull trap can be thought of in a similar way - it may appear that a stock or market is experiencing a period of growth, but in reality, it is just a false promise that will lead to disappointment and possibly losses. Just like the false trail sign in the mountains, a bull trap can lead investors to make decisions based on false information.
History of the Term Bull Trap
The term "bull trap" emerged in the 1970s, coinciding with the rise of technical analysis and the increasing use of charts to identify market trends. As traders and analysts began to dissect price movements more closely, they recognized the existence of false signals that could temporarily lure investors into believing a bullish trend was underway, only for the market to reverse course and continue its downward trajectory.
The concept of bull traps has gained prominence in the financial world, as they can have significant implications for investors' decisions and overall market sentiment. Recognizing and avoiding bull traps is a crucial skill for traders and investors, as it can help them protect their capital and make informed decisions based on genuine market trends rather than false signals.
Examples
Dead cat bounce: A dead cat bounce is a temporary recovery in the price of an asset that is followed by a continuation of its downward trend. It gets its name from the notion that "even a dead cat will bounce if it falls from a great height." Like a bull trap, it can mislead traders into thinking that a price reversal is underway.
Pump and dump: A pump and dump scheme involves inflating the price of an asset through false, misleading, or exaggerated positive statements, or even manipulative trading activity, before selling off the asset at a profit. The goal is to create a buying frenzy among investors and then take advantage of the high demand to sell off the asset at a profit, leaving investors with a worthless asset.
False breakouts: A false breakout occurs when an asset's price breaks through a key level of support or resistance but then quickly retraces back in the opposite direction. False breakouts can deceive traders into thinking that a major price movement is underway, only to be followed by a reversal in the other direction. Like a bull trap, false breakouts can lead traders to enter positions in the wrong direction.
Related terms
Bull: A bull in investing is an investor who expects stock prices to rise in the near future and is therefore willing to buy and hold stocks for the long term.
Bear Trap: The term "bear trap" is used to describe a situation in which investors who are bearish, or expecting further declines in asset prices, are caught off guard by a sudden and unexpected reversal in the market.